Weekly Note - January 11, 2023 - Update of Valuation Ratios and Corporate Earnings

 The note below covers:

1. Valuation Ratios for the DJIA are Still High
2. Corporate Earnings Have Not Yet Come Down

1. Valuations for the DJIA are Still High

Stepping outside the MRI framework, the valuations of the companies in the DJIA are still high compared to their valuations between January 2000 and last Friday (1/6/2022). Figure 1 below shows the current ratios and historical reference points. Please see this page for a brief description of these ratios.

Figure 1

The Price/Book (P/B) and Price/Sales (P/S) ratios are most important for this discussion. They are still high compared to the range of values since January 2000. As one can see in Figure 1, the percentile rankings of the current values are both above the 90th percentile. These figures mean stocks are expensive based on recent actual book values, sales, and earnings.  

In order for these high levels to be justified, corporate earnings growth will need to be strong going forward. In a time of slower economic growth induced by the Federal Reserve with higher interest rates, an outlook for especially strong economic growth does not seem to be the most likely scenario.  

Historically, these valuation ratios are low at market bottoms, and the ratios are shown for three recent market bottoms. DJIA prices will need to fall further to achieve those levels. In my elaboration of the industry adage “A Bull Market Climbs a Wall of Worry,” point #3 is relevant here – the current high valuation ratios suggest that stock prices will fall more than they already have.   

2. Corporate Earnings Have Not Yet Come Down

Figure 2 below shows the price of the DJIA (log scale, brown line), with the Peak-Earnings Indicator (PEI) in yellow. Last Friday is at the far right. The current major decline of the DJIA, which began in December of 2021, is indicated by “D”. The PEI has signaled that corporate earnings have been abnormally high throughout much of 2022. While earnings for the companies in the DJIA (shown by the double blue line) have declined somewhat since the mid-2022, they not yet declined as much as they have after the prior declines A, B, and C. Note that the declines in actual earnings typically occur several months AFTER the PEI has itself peaked.  

Figure 2

If historical patterns hold true, corporate earnings are likely to continue to decline further from here. If you would like to read my discussion of the PEI, I describe it here.

Based on the PEI and this analysis, the effects of a recession have not yet been seen in corporate earnings. Corporate earnings are likely buoyed by the ample Covid stimulus still in the system. That stimulus is helping to drive inflation, and the Fed is trying to dampen the effects of that stimulus. Thus, the economic battle between inflation and recession continues.